Noodles & Company looked like it might be the perfect pasta IPO, but sadly has a few flaws that keep it from being the next Chipotle Mexican Grill, Inc. (NYSE:CMG). Everyone is always looking for the next Chipotle and each new restaurant chain going public makes us hope this is the one. Noodles & Company comes close but falls a little short. It may still be investment-worthy depending on the opening price.
Chipotle Mexican Grill, Inc. (NYSE:CMG) is a freak of nature – I’m convinced. What other restaurant has been able to create double-digit growth in same-store sales quarter after quarter, all the while maintaining some of the highest margins in the business? Granted it has slowed a bit in recent quarters, but it still has numbers that are the envy of the industry.
The best restaurants have:
Food that creates high traffic – at present, high quality ingredients are a successful fast-casual concept
Positive same-store sales – higher is better
Traffic increases that are higher than price increases. This makes stronger comps – hard to do
Stores that are relatively inexpensive to build with low costs before opening
Increasing average weekly/yearly sales
Ability to add a substantial number of stores without saturation
Low costs/high margins
Noodles is built on a model similar to Chipotle and has most of the “best of” features:
Cheap-to-build stores fitted to locale
Mostly fixed menu with a stable of fresh ingredients mixed and matched to the customer’s order
Open kitchen
Low-priced fast-casual menu
Fast order fills
Double-digit growth
Two of Noodles’ executives — Chairman and CEO Kevin Reddy, 55, and President and Chief Operating Officer Keith Kinsey, 58 — came to the company in 2005 by way of McDonald’s and then Chipotle Mexican Grill, Inc. (NYSE:CMG).
Low saturation at outset and room to grow
Margins are disappointingly low and while same-store sales are positive, they only hit mid-single digits. Margins and comps don’t come close to rivaling Chipotle.
Noodles IPO and concept
The company just filed its prospectus and hopes to raise $75 million with an unknown number of shares (at present). The cash will mostly be used to pay down debt, helping low margins by removing interest expense. The buzz is it will raise far more than this and will be a hot and much-anticipated IPO. Investors love restaurant IPOs. Expect the initial offering to be bid up quickly, but it may correct when (or if) the reality of its industry-trailing margins and average comps materializes. Management may anticipate and work to improve both margins and same store sales proactively. The CEO and COO have put time in at two industry leaders, Chipotle Mexican Grill, Inc. (NYSE:CMG) and McDonald’s, and presumably have the skills to understand and fix problems.
The restaurant is a fast-casual concept serving lunch and dinner that opened in 1995. The menu is noodles and pasta made with fresh ingredients offering everything from Pad Thai to Mac & Cheese. Noodles also does soups, salads and sandwiches. Every meal is cooked to order and can be customized to personal tastes. The food is made to go or eaten at the restaurant. Sit-down service is on china plates with silverware — not plastic baskets and sporks. This is probably one area where it can’t compete with cost-controlled Chipotle margins. These restaurant operating costs are high for Noodles and the expense of plates and flatware is an expense Chipotle Mexican Grill, Inc. (NYSE:CMG) doesn’t have.
Noodles features open kitchens that are becoming quite the rage in the restaurant world, presumably because guests can see the freshness of ingredients and watch their food being cooked.
A meal is a value with the single check averaging around $8. Noodles has 339 restaurants with 288 company-owned and 51 franchised locations across 25 states. There is room to expand and the concept does not run up against a lot of other fast-casual concepts. I would hazard an opinion the pizza and burger spaces are reaching saturation. Between 2008 and 2012, the compound annual growth rate was 15.2% for revenue and 67.5% for operating income.
There has been steady (if not spectacular) growth in comps in 28 of the last 29 quarters due primarily to an increase in guest traffic. Increasing traffic is a much stronger indicator of quality growth rather than increasing menu prices. System-wide comp growth for 2010, 2011 and 2012 was 3.7%, 4.8% and 5.4%, respectively. Between 2008 and 2012, the compound annual growth rate was 15.2% for revenue and 67.5% for operating income. Average unit volumes (AUV) grew from $1.1 million at the beginning of 2010 to $1.2 million at the end of 2012. For comparison Chipotle has a 2012 AUVs of $2.1 million up from $1.8 million in 2008. Chipotle has been able to build traffic across restaurants, creating a $300,000 average increase per unit over 5 years.
New Noodles restaurants cost approximately $725,000 to build, net of tenant allowances. This is cheap capex for a fast casual building. Chipotle spends $800,000, BJ’s Restaurants are $4 to $5 million per unit and an Olive Garden can be built for $1.5 to $2 million. This allows the company to start collecting a cash-on-cash return of 34% after three years. Operating cash flow does not cover capex yet even with the relatively low construction costs. They built 37 stores in 2012, up from 27 in 2011. The increase was 15% matching the 15% increase in cash from operations. It still fell short of covering capex by $15 million. They may need to use debt at some point to build new stores. The company anticipates an annual 15% new store growth rate up to 2,500 locations. Increasing debt risks decreasing net margins. Investors can anticipate that proceeds from the IPO used to pay the current debt will eliminate or at least decrease interest expense providing a catalyst of sorts for margin expansion and faster net growth. More debt could reverse that.
Margins and Growth
Margins at Noodles are comparable to the sector favorites until we get to operating margins. The cost of sales, labor and occupancy are all in line with the investor-favored concepts including Chipotle Mexican Grill, Inc. (NYSE:CMG), BJ’s Restaurants, Inc. (NASDAQ:BJRI) and Panera Bread Co (NASDAQ:PNRA).
Margins
Gross #1 margins are cost of sales only
Gross #2 margins include labor.
Of the four, Noodles has the lowest operating and net margins and will need higher numbers to make them a great investment. Noodles total gross margins (food, beverage, packaging, labor) are in-line with their peers. It’s operating costs and interest expense that are killing the net and operating margins.
Operating expenses cover a lot of territory including marketing, administrative, occupancy, depreciation, pre-opening expense and a catchall called “other restaurant operating costs”. For most of these companies, occupancy expense (largely rent) is separated from other restaurant operating costs. That allows us to see if there is a built-in advantage for any particular chain in rental expense. BJ’s Restaurants, Inc. (NASDAQ:BJRI) combines occupancy and other operating expense and occupancy percentages cannot be calculated.
Occupancy as a percentage of revenue
Occupancy costs are over 3% higher than Chipotle. Every little bit hurts their margins when comparing to the best in class.
Combined occupancy costs/other operating expense percentages:
While some of the operating costs are within a few percent of each other across these companies, high “other operating expenses” for BJ’s. Panera Bread Co (NASDAQ:PNRA) and Noodles creates lower operating and net margins. Part of that expense is restaurant supplies that includes tableware for sit-down dining. Chipotle has no such expense and it counts the expense of its lower cost food packaging in cost of sales, making their operating costs low. Panera’s low combined expense is especially impressive since they also have higher cost restaurant supplies for sit down dining.
Why go on and on about this? Noodles has the highest expense and the lowest margins. What we hope for if we invest is they will be forced to be competitive (to make investors happy and the stock price going up) in the fast casual space. Margins will have to expand and cutting operating expense is a place to start. It obviously can be and is done successfully at Chipotle and Panera Bread Co (NASDAQ:PNRA). With the CEO and COO backgrounds at McDonald’s and Chipotle Mexican Grill, Inc. (NYSE:CMG), they may be able to make it work.
Growth and Same Store Sales
Growth at Noodles compares favorably to the other three investor favorites: Chipotle, Panera, and BJ’s Restaurants, Inc. (NASDAQ:BJRI).
Noodles & Co. 5-year growth rates
Chipotle growth in revenue, gross, operating and net is more than 20% the past few years. Panera is a close second with revenue growth in the high teens and the rest in excess of 20%. BJ’s lags with slowing growth, declining to the mid-teens for revenue and sliding into negative numbers for operating and net income.
Same store sales at Noodles are increasing and even beginning to approach the mighty Chipotle Mexican Grill, Inc. (NYSE:CMG). Chipotle comps decreased to 7.1% in 2012 for the year (11.2% in 2011). Panera Bread Co (NASDAQ:PNRA)’s 2012 comps were 6.5% and largely due to price increases. BJ’s Restaurants, Inc. (NASDAQ:BJRI) saw 3.2% comps made possible only by a 3.3% increase in price and mix offset by declining traffic. Price increases were the basis for these three restaurants positive comps and they struggled to increase traffic. Noodles comps were 5.2% and the company says it was due to traffic but gives no number.
Noodles comps and AUVs
Average unit volumes (AUV) are in thousands
Both AUVs and same store sales have been increasing.
There is a lot to like about Noodles & Company. Growth, same store sales and gross margins are the equal of other investor favorites. They have room to grow, have low restaurant building costs, competitive meal prices, increasing comps and AUVs, with a Chipotle-pedigreed management team.
The margins are concerning and without more years of data and listening in on conference calls for information, we can’t tell if these are amenable to improvement. The investing community loves a good restaurant story and this may be one. It almost certainly will price high and go higher until they have the opportunity to disappoint with slowing growth and worsening margins. Clearly, we can’t know how that will turn out, but the IPO deserves our attention.
The article The Practically Perfect Pasta IPO originally appeared on Fool.com and is written by jean graham.
j graham has no position in any stocks mentioned. The Motley Fool recommends BJ’s Restaurants, Chipotle Mexican (NYSE:CMG) Grill, and Panera Bread (NASDAQ:PNRA). The Motley Fool owns shares of BJ’s Restaurants, Chipotle Mexican Grill, and Panera Bread. Jean is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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